Social InSecurity: Looking for Answers in the Equity Markets.

The U.S. Social Security system is expected to be technically insolvent by 2034 or before. Would investing the Social Security trust funds in the U.S. equity markets be a panacea?

Despite President Clinton recently abandoning his longstanding call to invest some of the Social Security trust funds in the stock market, the debate continues. And FEI's Committee on the Investment of Employee Benefit Assets (CIEBA) participates in the discussion. CIEBA recently commissioned research on the impact of various trust fund investment proposals on the U.S. financial markets from four firms: Goldman Sachs, INVESCO, Morgan Stanley Dean Witter and J.P. Morgan Investment Management. The results were presented at "ERISA at 25: Applying the Experience to Social Security Reform," hosted by CIEBA and the Employee Benefit Research Institute.

Perry Johnson, COO of INVESCO Global Strategies, was asked, "Are we already doomed by our demographics?" Here's what he said.

Demographics vs. Economics

Since 1984, as baby boomers hit their prime earnings and savings years, ages 40 to 60, they've had a profound positive impact on our financial markets and the economy. As their retirement savings increased, so did the aggregate equity allocation of all U.S. investors. This, in turn, produced above average returns and significantly increased the size of the equity market relative to the economy. From 1980 to today, for example, the equity market has provided a real rate of return (the return above inflation) of about 13 percent - more than twice its historic average.

This positive impact should continue until 2006, when the ratio of prime savers to the overall population will peak at 36 percent. Then the positive effects on the market will reverse as boomers retire and the cohort moves from being prime savers to dissavers. Above-average equity allocations will slip toward average, then below, as the group's risk tolerance falls. The size of the equity market relative to the rest of the economy will dip below average; market risk premium relative to inflation will rise above average.

The market's forward-looking risk premium (the real return above inflation) is now 3 percent. The proxy we use to estimate its future real return is the current earnings yield (e/p) for the S&P 500, based on the notion that earnings derive from real assets and so should provide a real return above inflation. Historically, the earnings yield has averaged about 6 percent, equal to the market's historic 6-percent real return. The market's current, relatively low earnings yield implies below-average future returns. Downward demographic pressure should continue through 2006, however, keeping the market's risk premium low. As boomers retire, the market's risk premium (or earnings yield) is expected to near 8 percent by 2026. As the drop in the market's risk premium from 15 percent in 1980 to 3 percent today yields above-average returns, its rise from 3 percent to 8 percent will eventually mean below-average returns.

Economists show that the bulk of our wealth accumulation (excluding housing) is from assets in defined benefit and defined contribution plans. And since our prime earnings and savings years are ages 40 to 60, most of that wealth probably belongs to boomers. Starting in 2006, the first baby boomer will turn 61; over the next 20 years, an estimated 36 percent of our population will retire.

Sylvester Schieber, a Watson Wyatt actuary, and John Shoven, a Stanford University economist, show in their 1997 study that pension assets (DB and DC) will fall from $28 trillion in 2040 to $15 trillion in 2065 as boomers spend their nest eggs. As funds flow from longer duration assets into shorter duration assets and are consumed, it seems logical that there would be an impact on the equity market - specifically, upward pressure on equity risk premium.

If an aging population pressures our financial markets as we expect, it must also affect the economy and the government's fiscal policies and health. Simply put, the government has guaranteed retirement and health care benefits, via Social Security, Medicare and Medicaid, to virtually every American. Positive demographics have resulted in the payroll-tax inflows attributable to these benefits exceeding outflows since the programs began. This should continue through 2006. However, since these are in principle "pay-as-you-go" systems, as boomers retire, outflows will exceed inflows; the trend will accelerate as this generation ages.

The Congressional Budget Office thinks if current benefit guarantees aren't cut, the ratio of public debt to GDP will grow to 300 percent between 2030 and 2040. These are third-world country statistics. At such levels, growth in government debt would outstrip the growth rate of the economy, causing a decline in national savings, slowdown in economic expansion and eventual fall in our standard of living. If the government used an accrual-based accounting system, the CBO estimates federal income taxes would have to jump 25 percent for the government to return to fiscal balance. Given the various forms of taxation, the overall tax burden on the economy would grow from about 33 percent to 60 percent.

Though potentially higher investment returns over the long run are a worthy goal, the problem can't be solved entirely by upping the funds' investment risk. At some point, we'll need a combination of higher taxes and benefit cuts to maintain the government's fiscal balance and to help assure that the burden of meeting the boomers' retirement and health care needs doesn't adversely affect the economy.

Social Security funding is tied to payroll taxes, which are tied to the growth rate in the economy, so healthy real economic growth is important to minimize the program's cost. In a high real growth environment, the expansion in real wages, and thus inflows, will exceed the growth rate of benefit payments, which are tied to inflation. With benefit reductions, this is the single most important factor in the vigor of the Social Security system. But the level of national savings would need to stay at a rate that encourages capital formation, which would enhance productivity and raise everyone's standard of living. In other words, the solution is for the economy to grow at a real rate that allows for the transfer of sufficient resources to retirees without overly penalizing workers. In many ways, it means the government mustn't inhibit productive deployment of the economy's resources. Although we expect several more years of budget surplus, the government must vigilantly contain future spending - especially spending related to social programs like Social Security, Medicare and Medicaid. Otherwise, higher interest rates and taxes will unduly burden the economy as demographic pressures threaten the government's financial condition. In this climate, the net cost of these programs could spiral even higher.

Social Security isn't a pension plan. After payroll taxes are collected and benefits are paid, any "surplus" goes to other government programs and is replaced with special Treasury Bonds. Irrespective of the mechanics, the money is spent; the government has an outstanding future obligation. Thus, in discussing the assets in the Social Security fund, one basically refers to government IOUs. Therefore, unless the government cuts spending elsewhere, investing trust fund assets in equities doesn't increase national savings. The total of debt and equity outstanding would be the same. Net-net, any potential government gains from higher equity returns would be offset by lower private-sector returns.

If some of Social Security is invested in equities, and assuming other government spending is cut, national savings would increase and positive benefits would accrue. However, at least this part of the system should be privatized. We recommend a 401(k)- or 403(b)-like structure, where asset management rests with the individual. based on the suggested funding levels, the government could become a substantial owner and investor in our economy. Given the potential of policy errors, the risks aren't worth the reward. Since the primary solution is to increase the productivity of the economy, increased government involvement could be counterproductive.

Of Risks and Rewards

Part of the presentation by William C. Dudley, managing director and director of the U.S. Economic Research Group at Goldman, Sachs & Co., at "ERISA at 25" involved a discussion of the riskiness of equity investment. This is what he said.

"The longer you hold equities, the less risky they are relative to bonds. Also, reductions in risk from extending the holding period dissipate as you extend the holdings. Still, you can't hold equities for 100 years with zero risk. So what's the chance of stocks under-returning bonds over different periods? It's high in the short term. But if you consider 30-year or 40-year holding periods, in most cases stocks won't under-return bonds. And in virtually no case will stocks have negative real returns over time. So equities are riskier than bonds but not by much, especially if the trust funds hold them.

"But there's a bigger risk. What happens if the equity risk premium returns to its historic norm or rises? Obviously, if the equity risk premium doesn't stay where it is today (and it's low, since p/e ratios are high), the equity market would dramatically under-perform bonds. Just a 1-percent rise would mean about a 25-percent equity market decline. Obviously, if the trust funds were fully invested while this was happening, you'd have a significant under-performance. The long-history analysis assumes a stable equity risk premium. If the equity risk premium moves dramatically, results could be worse.

"Finally, look more broadly than the 60/40 mix or 50/50 mix of equities and treasury bonds to other asset classes: corporate bonds, high-yield debt, mortgage-backed securities, etc. You'd probably increase returns at the same or a lower level of risk for the same returns, vs. a "barbell" strategy of a high proportion of equities or treasury bonds."